Question of Honor for Fund Manager

Seventy-four years is a long time for a financial services company to go without making some big, highly embarrassing blunder.

That may explain a lot about the defiant reaction of Los Angeles-based Capital Group Cos., parent of the American-brand mutual funds, as three regulatory agencies bear down on it for alleged violations of securities laws.

Capital Group, founded in the Depression, has become one of the world’s biggest money managers by producing above-average long-term returns for clients without taking untoward risks.

Many investment firms describe themselves as conservative in handling clients’ money, but that is religion at Capital. Likewise, the company has always stressed that it placed integrity above all else in its operations.

The lack of a regulatory rap sheet, after 74 years, suggests either that Capital has been serious about clean living -- or that industry cops haven’t dug deeply enough to find wrongdoing.

The latter conclusion was implicit in a case filed against Capital’s mutual fund arm last week by the NASD, the securities industry’s self-regulatory agency.

The complaint alleged that American Funds Distributors Inc. broke securities rules by offering improper incentives to brokerages that sold its mutual funds from 2001 through 2003.

The case took the fund industry by surprise. It has been widely known for months that the Securities and Exchange Commission and California Atty. Gen. Bill Lockyer have been jointly investigating American Funds. Many industry insiders expected either the SEC or Lockyer, or both, to bring a case soon.

The NASD, formerly the National Assn. of Securities Dealers, beat the SEC and Lockyer to the punch -- although, because the NASD ultimately answers to the SEC, it was clear the two had coordinated. (The NASD, in filing its complaint, thanked the SEC’s West Coast office for its “substantial assistance.”)

The case, and the probes by the SEC and Lockyer, are part of Round 2 of regulators’ investigation of fund industry practices.

Round 1 was sparked by New York Atty. Gen. Eliot Spitzer in September 2003, when he revealed that some prominent fund companies had allowed favored clients to engage in “market timing” and other abusive short-term trading schemes that effectively stole profit from long-term investors.

In Round 2, which has been ramping up since last spring, regulators have focused on long-standing fund marketing practices -- in particular, payments that fund companies have made to brokerages to promote fund sales.

The payments weren’t secrets. The SEC has for decades permitted fund companies to offer certain compensation to brokerages to highlight fund products to brokerage sales forces. Those payments are in addition to standard brokerage commission charges on fund sales.

The catch has been that there are limitations on quid pro quo arrangements between fund companies and brokerages -- deals that assure specific payments for specific sales.

Otherwise, there could be an overwhelming incentive for brokerages to favor the funds that pay them the most -- even if those funds aren’t the best choices for investor clients.

The NASD alleges that American Funds in fact had improper quid pro quo sales agreements with about 50 brokerages from 2001 through 2003. By meeting certain sales targets, the brokerages knew they’d share in a pool of money that totaled about $100 million in that three-year period, the NASD said.

The money was awarded through a practice known as directed brokerage: As American Funds bought and sold stock for its huge fund portfolios, it had to decide which brokerages should get the commission-generating trades. Many of those trades were directed to brokerages that had met sales targets for American Funds, the NASD said.

American Funds doesn’t dispute that. But it insisted last week that fund sales by brokerages were merely a “consideration” in its directed-brokerage decisions, as permitted by SEC rules.

In a reply to the case posted on its investor website, the company said it “never committed, either formally or informally, to direct a specific amount or percentage of portfolio transactions to any firm.”

American Funds vowed to fight the complaint when it is brought before an NASD hearing panel. But in its usual style of keeping a low profile, the firm wouldn’t say much more.

In one sense, the case is moot: The SEC banned directed brokerage last year.

“This is like calling a foul after the game is over,” said Roy Weitz, who operates FundAlarm.com, an industry watchdog website.

If it goes head-to-head with the NASD, American Funds will have many securities lawyers rooting for it. Some believe that the crackdown on fund companies is out of control, and that regulators are engaging in a form of legal extortion by attacking companies for practices that were largely unchallenged for more than a decade.

“In my 29 years in the business, this is the worst climate I’ve been in” in terms of regulatory fair dealing, said Cheryl Moore, a partner at law firm Patton Boggs in Dallas.

But there’s a reason virtually all fund companies charged with wrongdoing agree to settle the cases, typically without admitting or denying guilt, Moore and other attorneys say: Even if a company believes it has been cited unfairly, to fight is to risk much bigger financial penalties and sanctions, including revocation of securities licenses.

In the case of American Funds, parent Capital Group is owned by 350 partners, not by public shareholders. That means the partners’ wealth is at stake if they go to war with regulators.

Honor is at stake too, however, and that is no small consideration in Capital’s corporate culture.

“I would be so disappointed if they settle” rather than fight, said Neil Bathon, president of Financial Research Corp., a Boston-based fund research company. “There are a lot of scumbags in this industry, but this firm absolutely is not one of them.”

In the court of public opinion, Capital and American Funds would seem to have a few things going for them.

One is that the NASD didn’t allege specific investor harm because of American’s directed-brokerage practices. Nowhere in the complaint did regulators suggest that some investors were sold American funds because their broker was trying to maximize compensation to his or her firm.

Brokers have had other good reasons to make American’s the best-selling mutual funds in the last two years, lifting the firm’s total stock and bond fund assets to $650 billion: After the devastating bear market of 2000-02, many financial advisors and their clients have had a much better appreciation of Capital Group’s conservative investment style, its low portfolio management fees and its focus on limiting losses in down markets.

Growth Fund of America, the biggest of the American funds, with $95 billion in assets, gained 14.1% a year, net of sales charges, in the 10 years ended Dec. 31. The blue-chip Standard & Poor’s 500 index rose 12.1% a year in that period.

In terms of performance, “it turned out best for brokers’ clients to be sold American funds,” Bathon said.

In contrast is a new fraud case against American Express Financial Advisors Inc. New Hampshire regulators on Friday alleged that the firm’s advisors, under pressure from management, sold clients “consistently mediocre” American Express-brand funds instead of better alternatives.

In its case against American Funds, the NASD conceivably could have alleged that the firm hurt fund shareholders by failing to get “best execution” on every stock trade.

In other words, if American Funds was directing trades to certain brokerages as a sales reward, it might have placed that consideration above the regulatory requirement that it send trades to the brokerages best able to execute them properly, and at the lowest cost (because trading commissions are paid out of fund assets).

But the NASD didn’t charge that American Funds violated best-execution rules.

Barry Goldsmith, head of enforcement for the NASD in Washington, said the agency’s case was a matter of principle: The law says fund companies can’t have quid pro quo sales agreements with brokerages.

“Our case is premised on a rule that prohibits this practice,” Goldsmith said. It doesn’t matter if investors weren’t harmed by the practice, he said.

For American Funds, the question of whether to continue to fight -- as opposed to settling the case, paying a big fine and moving on -- also is likely to come down to a matter of principle, say fund industry analysts who know the firm well.

Was the company simply greedy, as the NASD implies in its case? Did it cross the line in trying to assure that many more billions of dollars would flow into its fund portfolios?

Or has the company been faithful to what its website says are the three principles that have guided it for more than 70 years: “Place shareholders’ interests’ first at all times; treat all shareholders fairly; and conduct our business honestly, ethically and with integrity”?

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Tom Petruno can be reached at tom.petruno@latimes.com.